How does liability-driven investing (LDI) work for pension funds?

Liability-Driven Investing (LDI) is a portfolio management approach where investment decisions are driven by the characteristics of the liabilities rather than an asset-only return target. It's primarily used by defined-benefit pension funds, insurance companies, and endowments with fixed obligations.

Why LDI?

Traditional asset-only management optimizes for maximum return at a given risk level. But for a pension fund, the real risk is not portfolio volatility — it's surplus volatility (assets minus liabilities). A pension fund can earn 10% on assets but still be worse off if liabilities grew 15% because interest rates fell.

The Core Idea

Match the interest rate sensitivity (duration and key rate exposure) of the asset portfolio to the liability stream so that both move together when rates change.

Implementation Steps

1. Model the liability stream: Project all future pension payments by year, reflecting mortality tables, salary growth, and inflation assumptions.

1. Calculate liability duration: Typically 12-20 years for a pension fund (long-duration).

1. Build the hedging portfolio: Use long-duration bonds, interest rate swaps, and inflation-linked bonds to match liability duration.

1. Overlay a return-seeking portfolio: Allocate a portion to equities, alternatives, and credit to generate returns above the liability discount rate.

Example: Mercer Pension Fund has $2B in liabilities with a modified duration of 15 years. Assets are currently $1.8B (90% funded) with a duration of 6 years. There's a massive duration mismatch — a 100bp rate decline would increase liabilities by ~$300M but assets by only ~$108M, worsening the deficit by $192M.

Under LDI, the fund would:

• Extend asset duration to 15 years using long bonds and receiver swaps
• Maintain some return-seeking assets to close the $200M funding gap
• Monitor the hedge ratio (assets × duration_assets) / (liabilities × duration_liabilities) and rebalance

Types of LDI:

• Cash flow matching: Buy bonds whose cash flows exactly match future liability payments
• Duration matching: Match the overall portfolio duration to liability duration
• Key rate duration matching: Match duration at specific tenor points along the curve (most precise)

For the CFA Level III exam, know the difference between cash flow matching and duration matching, and be able to recommend the appropriate LDI glide path as funded status improves. Explore our CFA III fixed income materials for more.